All the king’s horses


Brett Lewthwaite

  • Executive Director, Chief Investment Officer and Global Head of Fixed Income
  • Read bio

Executive summary

In this special edition of Macquarie Fixed Income (MFI) CIO note, we provide insights into how the team is viewing the evolving environment, detail the framework with which we are assessing the situation, and outline our thoughts on possible broad and market specific implications due the outbreak of the COVID-19 virus.

For many years, we have used the concept of the “contained environment” to describe and assess the market backdrop. Since the global financial crisis, central banks have repeatedly been required to act to contain risks and prevent any faltering in the economic growth outlook. Financial markets embraced this support leading to many unintended consequences – an insatiable chase for yield disconnected from fundamentals, negative global bond yields, increased debt, and dependencies to name a few. We have long questioned the sustainability of this fragile backdrop and asked, “what then could end the contained environment?” To this we have responded that possible factors could be a pickup in inflation that would prevent central banks from continuing to offer stimulus or a situation whereby central banks act. However, growth slumps regardless. This could take the form of a geopolitical event, a natural disaster, or indeed a pandemic.

The outbreak of COVID-19 and its rapid global spread have resulted in a supply, demand, and health shock that have knocked over the contained environment and stopped global economic growth in its tracks. Countering this is the incredible response we have seen from central banks and governments globally, which have acted swiftly and meaningfully to support economies. The interplay between these two forces will be critical in assessing where financial markets settle, and likely we can expect much volatility, with conditions reflecting that of a bear market, until such time that there can be some sense of when economies can begin to resume prior activities.

The fallout from this crisis will be widespread and we detail in this piece some key areas we believe will see significant short- and long-term disruptions or changes that will factor into assessing the longer-term outlook.

Prior to the global COVID-19 crisis, at our MFI January Strategic Forum we noted how we had already moved to being more defensive during 2019, cautiously participating in risk markets, and accumulating duration on yield backups. As the crisis ensues, we continue to maintain this defensive stance and focus on liquidity, as our clients and our clients’ clients depend on fixed income to deliver this in times of stress. We have been selectively allocating to sensible opportunities, focused in higher quality, defensive sectors, believing there will be ample time to participate in broader opportunities. We will remain prudent and patient as the situation continues to evolve.

March 2020 | From containment to crisis

By suppressing volatility, central banks created a system unable to deal with bad news. Or to put it another way, leverage was built up on the premise that nothing bad happens. And something very bad has now happened.

Andrew Lapthorne

The contained environment wasn’t ever a conscious decision; it was more an unintended consequence of the post financial crisis world of sub-par growth. In fact, even the concept of containment was flawed. There were always going to be negative side effects to these actions and the reality that it couldn’t insulate markets and economies from a shock, particularly one as severe as the COVID-19 virus, that by definition, could not have been predicted.

Since the global financial crisis, more and more quantitative easing (QE) and stimulus helped to support higher and higher asset prices. As these prices reached a seemingly invincible peak, the COVID-19 effectively burst the container, spilling all engrained patterns, behaviours, and risks at once. While we do not know how many in the financial system were complacently extracting every last drop of yield and spread in all their levered forms, the violent market reactions during March suggest there were many, and potentially still are many.

Coronavirus has disrupted both supply and demand, and it is the demand slump that is particularly acute with travel, mobility, and non-essential services restricted in most parts of the world.

At MFI, we view the situation as the interplay between two very large and opposing influences: 1) the global synchronised sudden halt of economies and 2) the incredible policy response by central banks and governments to address the impact that is being acutely felt by so many. It is the interrelation between these two forces that will determine where market prices settle and likely we can expect much volatility, with conditions reflecting a bear market, until such time that there can be some sense of when economies can begin to resume prior activities.

Adjacent to these forces are additional considerations such as the impact on society and longer-term implications that we can’t foresee just yet.

The sudden stop in the global economy | The economic impact

We have all seen the COVID-19-by-country charts, and we understand health authorities’ social distancing response to manage them. This response has created a sudden halt in global economies, which in turn has created a massive economic shock – think “chain reaction.” We do not yet know the extent of the economic impact; however, we know it will be deep. It is far more widespread in its impact than the global financial crisis, and again it will have a large impact on many lower income workers. You only have to speak to a neighbour or a family member to know how far and wide the impacts are. Everyone is affected, everyone is worried, everyone is watching – with social media providing a new element of ongoing, live, unfiltered coverage. The other question linked to how deep the impact is how long the impact will be. The aim of social distancing is to flatten the curve and draw out infection rates so as not to overload the health care system. It is not yet clear that flattening curves could predict the resumption of economic activity, as the risk of renewed flare-ups will be very real. We remain alert to the possibilities that perhaps the virus can burn out, a sufficient medical treatment could be found, or even some (perhaps younger) parts of society could ”just get on with it.” These are all possible.

Reflecting on our January 2020 Strategic Forum

Views presented in the January Strategic Forum commentary

In summary, our view following our deep dive review of economic data confirmed some signs of stability toward an uptick in global growth. However, the backdrop is a fragile and fatigued global economy that continues along a path of underwhelming expansion that is vulnerable to any modest shock.

Containment: Central banks respond again

Reflecting on the outlook within the framework of the “contained environment” and assessing the effectiveness on growth, the key question in our minds is: Would the China led global slowdown ultimately become a recession and impact markets in the way a recession normally would? Or would the central bank response and consequent re-emergence of the insatiable global chase for yield keep credit markets open and functioning freely despite the deteriorating fundamental outlook? In early 2020, it appeared the global chase for yield was gaining the upper hand. With recession risks elevated, it is imperative that credit markets remain open.

While risk markets have been enjoying the fresh application of policy stimulus, in our minds it is still uncertain as to whether the “response” transmission through to economic growth would be meaningful enough, particularly as this time the predominant driver of the prevailing slowdown was structurally slower China growth. This is why we have been wary of the extent of the financial market response and believe it may be vulnerable to a correction.

We have long pondered about how markets have become increasingly accustomed to the pattern of the last 10 years of embracing any and all policy comforts afforded, and in doing so have seemingly demonstrated just how dependent they are on this support.

Even if the initial response from risk markets has been to dismiss such troubling dependency concerns and embrace the prospect of more stimulus – with which markets have become more and more familiar, and we would argue too complacent – with a “buying the dip” mentality, markets have slipped comfortably back into the warm embrace of the “more stimulus, please!” contained environment.

Central bank firewall: Susceptible to a virus?

We have often been asked what could end the contained environment? To this we have referred to the possibility that something would eventually crack or tip the container over.

In our minds, this outcome would most likely come from one of two forms: a pickup in inflation preventing central banks from continuing to offer stimulus or a situation where central banks act, while growth slumps nonetheless. This could take the form of a geopolitical event, a natural disaster, or indeed a pandemic. This leads us to the risks posed by the coronavirus, which emerged shortly following the Strategic Forum.

The immediate concern for markets centres around how the reduction in mobility might impact growth, in particular in China, but also more broadly. This is an unwelcome development in an already fragile growth environment particularly given the importance of China to the global supply chain and therefore the global economy. Factoring this turn of events into the growth outlook and one can only downgrade it in the short term.

Adding this to our already more cautious than consensus outlook for growth, and then considering that markets have already priced a much better growth outlook leaves us concerned that the early 2020 optimism will be very difficult to be delivered upon.

To us, a more serious question worth pondering is whether the coronavirus will test the central bank contained environment – indeed, it seems very likely that more easing will be required, however its effectiveness is questionable as the virus would primarily impact main street and not wall street. Given the low altitude growth environment, and to use the technical terminology, indeed could the central bank firewall be susceptible to a virus infection? This is a risk that should not be dismissed.

There is some consensus optimism emerging that eagerly highlights China’s re-ramping of manufacturing. We would caution that since the pandemic has had a domino effect, the full recovery led by manufacturing is not likely to start until after the last domino falls (the US and Americas generally, and then there are the developing and emerging market countries to consider).

And so, for now the uncertainties regarding how long remain significant. A V-shaped recovery seems unlikely. In terms of global growth, we thought this was serious when it was localised in China; now it is global.

All the king’s horses | The incredible monetary and fiscal policy response

Central banks have reacted swiftly, reducing interest rates to effectively zero (if they were not there already) and introducing an extended array of unlimited QE-like programs to ensure the financial plumbing keeps functioning. They are doing everything they can to keep liquidity and credit flow functioning, including moving down the capital structure into certain high yield corporate debt and ETFs. In effect, they are keeping the heart beating and the blood flowing to their respective economies. Without this, we believe we will have a deep economic shock, followed by a consumer/unemployment recession/depression that meets a financial market system engrained in what was previously a complacent and contained environment.

This massive monetary response should help ensure that the financial plumbing works. However, the probability of a financial accident (that can literally come from anywhere in the current environment) has not been completely eliminated. Importantly, this time around the crisis did not originate in the financial system but stems from an exogenous economic shock, so it may take a while for all its effects to filter through. Helping the situation this time around, banks are generally in a better shape, although the risks have shifted to non-bank financial institutions.

In terms of the fiscal response, the exogenous nature of the pandemic requires governments to also do “whatever it takes” and do it faster than during past crises. As such, governments everywhere have announced fiscal packages that are, in effect, attempts to build fiscal support bridges that slow consumer retrenchment, keep people employed and aimed at getting them through to the other side of the slump. Examples (such as in the UK and Australia) include packages whereby governments pay a percentage of wages of companies forced to stop production – through the companies themselves. This allows companies to stay open, pay their staff, ensure that people can have security, and allow companies to be ready to go again when this passes.

We find it difficult to call this “stimulus” as it is often referred to in the media; we view this more as a rescue than measures intended to spur activity. We anticipate that these activities will to some degree offset the slump, and contain the fallout and chain reactions.

We think of this as a COVID-19 economic hole that keeps getting deeper, and these fiscal responses are trying to fill the hole. For the near term, the hole gets deeper quicker than the policy response offset can fill it. The size of the hole is unknown and will depend on “how long?” and “how deep?” this contraction ensues. In conclusion, policymakers have moved from pre-crisis containment to rapidly building bridges to the other side.

Can this incredible policy response counter the economic drawdown and create the much-needed bridge to the other side? We believe that eventually it will. Markets too, are full of vested interests that will pursue this narrative, and other supportive measures, with force that should not be ignored. However, in our minds, while this is the likely eventual outcome, it may not be at current market pricing levels, as we are yet to ascertain the depth and duration of this downturn.

A very different crisis | A pandemic shock

This pandemic shock has hit a levered financial economy rather than the old-fashioned business cycle economy. We are in an economy that utilised financial engineering and optimised leverage based on “certain” future cash flows. Cash flows that have now slowed dramatically, if not stopped outright.

We appreciate the debate surrounding the concepts of V, U, or even L shaped recoveries. However, we question whether “consensus” appreciates that the shock arrived at a vulnerable stage in the elongated global economic cycle and to a financial system that previously could not endure even a mild slowdown without central banks ”just doing more” to stimulate, let alone address a sudden stop.

This crisis disrupts over 30 years of over-utilised monetary policy with few or no periods of genuine creative destruction. This ultimately culminated in a sense of a central bank-contained environment, where buying the dip was the norm and chasing yield went to incredible extremes.

Central banks can help ensure the functioning of financial markets, the credit market in particular, thereby limiting the panic in the markets. However, central banks cannot stop the spread of the virus, the impact on hospital systems, the time frame, the possibility of additional waves (even as the first may not peak for some time), and ultimately the reaction and behaviour of societies.

The aftermath | Near and longer-term considerations

The fallout from this crisis will be widespread with near and longer-term consequences, some of which we know and some that will only appear in time. Below we have captured what we believe will be some of the more acutely impacted areas.

  • Economies | The impact of effectively shutting down economies will be severe. The loss of jobs is real, worse than any other than the Great Depression. We expect gross domestic product (GDP) to fall globally and unemployment rates to soar.

  • Fiscal deficits | Most governments already had higher debt levels than was the case pre-global financial crisis. Additional fiscal spending in the current environment will add in some cases, significantly to those overall debt levels and potentially raise sustainability and financing stresses. Ultimately there will be concerns about these high debt burdens, particularly in the developed world with its shrinking population. It’s difficult to see how these countries will grow out of it. Could this mean a return to inflationary policies or a loosening of inflation targeting regimes?

  • Central bank policy | Central banks had already moved far from “normal” activities in their efforts to support economies pre this crisis. Now, they will have to venture even further. Purchasing debt in tandem with Treasury issuance, yield curve control, or monetisation are policy ideas that were once unthinkable, but are now almost expected, yet with consequences not yet fully understood.

  • Central bank induced dislocations | The US Federal Reserve’s support of certain assets including investment grade corporates, agency structured securities, and now certain high yield corporates and ETFs may cause regime shifts with their lower rated, non-agency, and emerging markets counterparts.

  • Non-financial corporates | Corporates who receive government bailouts are likely to see enhanced regulation and scrutiny on their actions, especially leverage levels and shareholder buyback policies, which have increased significantly in recent years.

  • Emerging markets | By and large, emerging markets (especially Latin America) do not have a lot of fiscal resources to mitigate the crisis. We expect the reliance on monetary policy and currency depreciation to increase. Many EM countries have learnt to live with currency volatility, so we believe currency weakness should not result in the overwhelming balance sheet problems (due to external debt) but pockets of vulnerability exist, especially for corporates. Global financial institutions (International Monetary Fund, World Bank) are likely to be more lenient in their lending practices to EM countries, especially poor EM. However, private bond holders may be roped in if the debt profile is deemed unsustainable.

  • Social behaviour | What will the new normal look like? Even when we return to work, social distancing is likely to remain a feature of behaviour for some time. This will impact travel, restaurants, pubs, and shopping. Again, this all tends to suggest a V-recovery seems overly optimistic. Perhaps a return to sluggish, or more sluggish, growth is a best-case outlook.

  • Geopolitics and deglobalisation | These two interrelated factors will not be the same post this crisis. Closed borders strain global supply chains, trade, and capital flows with the crisis also bringing the realisation that key national security supply chains often sit in unfriendly and/or competitor countries.

Investment implications

The MFI team entered the global COVID-19 crisis already broadly defensively positioned reflecting our view that the initial optimism of the 2020 growth outlook was likely overly optimistic and already priced into markets.

As the crisis ensues, we continue to maintain this defensive stance and focus on liquidity, as our clients and our clients’ clients depend on fixed income to deliver this in times of stress. Of course, where sensible opportunities present, for example in higher quality assets, we will continue to participate.

Going forward, the significant repricing of asset markets presents a considerably increased array of potential opportunities for us to capitalise on once volatility subsides. Over the last several years we have not utilised the breadth of our ability to allocate to many of the higher yielding sectors believing that there was not enough reward for the risk. This balance is now clearly changing, although we believe there will be ample time to participate in these opportunities and will remain prudent and patient as the situation continues to evolve.